Your New Custom Home: Refinancing a Construction Loan

If you are finally planning to build your dream home, you'll probably need to arrange a construction loan: housing data from the 2000 Census indicate that only about 20% of those building a custom home have the means to pay cash. Here are some tips for financing construction of your dream home.

Construction Loans

Construction loans are short-term mortgages lasting only through the actual home construction process. Your construction loan can be used to purchase the building lot, and will disburse funds for each of the major phases of construction (i.e., foundation, framing, plumbing, and finish work) until the home is complete. Upon completion of the home, your construction loan becomes due for repayment, and traditional long-term "permanent" financing comes into play.

Two types of borrowers typically seek straight construction loans:

  • Owner-builders: Owner-builders act as their own contractors. Because there is no way for the lender to be certain beforehand that the home will truly be owner-occupied (instead of marketed as a speculative home), owner-builders are typically limited to a straight construction loan.
  • Rate Shoppers: Rate shoppers simply want to be free to shop for the best permanent mortgage rate when the construction is over, then refinance to their permanent home loan.

The primary risk of not arranging permanent financing prior to construction is that, if for some reason you do not qualify for permanent financing upon completion of the home, you may be forced to sell your dream home without ever having lived there--or else face exorbitant interest rates from a "private" lending source, if you can find any.

Construction-To-Perm Loans

A construction-to-permanent loan (often called "construction-to-perm") combines a construction loan with a permanent, long-term mortgage. Generally, the interest rate during the construction phase is relatively unimportant, because the loan period is very brief (say, 8-18 months), and you typically pay only the interest charges during that time, not principal. However, you can still refinance either loan if that saves you money.

A construction-to-perm loan simplifies your financing as follows:

  • No multiple loan applications
  • No multiple loan documentation processes
  • No multiple signings at the title company
  • No multiple payments of lender fees and title/escrow charges

A construction-to-perm loan can be very convenient for many people, and is a very common choice when building a custom home. However, construction-to-perm loans deliver your lender its loan fees upfront. You won't necessarily know your long-term mortgage rate until construction is complete--but you will still be obligated pay that potentially higher-than-necessary rate for many years thereafter.

Some mortgage lenders offer options for 'floating' down the long-term rate on your construction-to-perm loan if mortgage rates drop during your construction period. If this option is available to you, carefully consider the fees and restrictions associated with such a rate float-down, which are specific to each bank.

Refinancing Your Permanent Home Loan?

Because the permanent rate may not be competitive, it can be worthwhile to consider refinancing your permanent home loan to a lower rate--in spite of the duplicate closing fees. If you only received a construction loan, you will almost certainly need to obtain long-term financing upon completion of the home.

When your new home is almost complete, start shopping for mortgage interest rates, then use a home refinance calculator to see if you can save by replacing your construction-to-perm loan with a newly refinanced mortgage. Collect Good Faith Estimates (GFEs) from brokers and direct lenders, and interview loan officers. You might even be able to bargain with your construction lender for a lower permanent rate if you bring in some competitive quotes from other lenders, without having to do a full refinance.

Refinancing Information: Avoid Pitfalls

Refinancing a construction loan is a bit different from refinancing a "normal" mortgage. Make sure that you preserve your good credit rating during the construction period, because your credit will almost certainly be checked again when you seek refinancing. If your credit score has dropped, it might push the best interest rates out of your reach; in the worst case, it may prevent you from refinancing your permanent home loan at all.

Also try to minimize your mortgage borrowing, in case property values decrease and your completed home appraises for less than anticipated. Borrowing to avoid might include loan fees wrapped into the loan, or an interest reserve account, which essentially wraps your interest payments during construction into the loan. In today's insecure real estate markets, such potential excess borrowing may push what you owe above the appraised property value, and could seriously hamper your refinance efforts.

Finding your builder, choosing your floor plan, selecting fixtures, and picking out materials can be challenging and may occasionally seem frustrating. But with online mortgage information and rate quotes, financing your dream home doesn't have to be.